ECB – A Sweet September Birthday Package

Published on September 4, 2014

The Euro, already under pressure going into today’s monthly European Central Bank Governing Council meeting, plunged to new lows, and Euribors have rallied sharply, on the back of the decision by the ECB today to cut interest rates across the board by 10 basis points along with its widely anticipated roll out of an Asset Backed Security (ABS) purchase program.

Rather than critique the ECB for cutting rates even deeper into negative territory after signaling in June that rates were for all practical purposes at their lower bound, or jump on a somewhat hollow bandwagon in critiquing the rate cut for being too small to be effective, we laud ECB President Mario Draghi and the European Central Banks for taking this bold step even deeper into uncharted territory.

And there remains little reason to believe the Euro will not continue the grind lower, continuing on the trend that kicked off in earnest at the June ECB meeting (see SGH 6/4/14, “ECB: A Deeply Complacent Market”).

While the vast bulk of economists and analysts did not expect a cut today, our understanding was that the ECB did in fact believe it had room for cutting by perhaps another 10 basis points before entering what could be dangerous territory on negative rates, where the potential benefits of low rates could be jeopardized in theory by the risk of incentivizing depositors to hold cash rather than keep money at penalty rates in the banking system. And we therefore saw a “reasonable chance” of a rate cut to be thrown in today in top of the rollout of the ABS program (see SGH 9/4/14, “ECB: Gut Check”).

It is all the more impressive that Draghi and the Executive Board pulled together consensus for the cut that was not without some internal controversy (you earn zero points for figuring out that one of the dissents was the Bundesbank), along with a slightly beefed up ABS program, and also in conjunction with a clear signal to do more, including on sovereign asset purchases, if need be, in the future.

All in all, we have to say Mario Draghi managed to deliver quite a nice birthday package to the markets today (September 3, 1947 – with apologies for including the year)!

In addition to helping keep pressure on the Euro, we would also highlight the very explicit signal Draghi sent to banks today that now, rates were at an effective (real) zero lower bound – and so they better grab some of that cheap TRLTO funding while they can. In fact, we are considering borrowing a page from the ECB and closing subscriptions to the SGH service on that basis now as well.

The other key developments to note today were the announcement of an intention to purchase covered bonds again along with the widely anticipated announcement of the ECB’s intentions to purchase ABS securities.

While we had expected the ECB to open to door to purchases of other types of private securities, in truth we had not thought to flag covered bonds specifically for this meeting, but it is of course a natural, and low hanging fruit, for a purchase program, given that the ECB had already conducted covered bond purchases in two previous programs in 2010 and 2011.

The problem with the previous programs was that the take up was in fact quite limited, but Draghi took pains today to point out that this new program is being designed specifically to boost the ECB balance sheet rather than directly target banks, and so the covered bond purchase will be part of a much broader initiative. The explicit inclusion by the ECB of the of the sizable mortgage backed ABS bond market in its securities purchase plan, as opposed to limiting the purchases to the far smaller, almost non-existent SME (Small and Medium Enterprise) based subset of ABS is also intended to explicitly reinforce the commitment by the ECB to expand its balance sheet.

In reality, however, while the ABS program is intended to be a “credit” program as much as a “quantitative” program, and presented as such, it is not so much the housing and mortgage markets that really need the most help in the Eurozone. While there certainly is a considerable amount of overhang in southern Europe from the boom days of the 2000s, housing remains firm in Germany and some other areas of Eurozone, and the examples of countries that have fueled a real estate bubble through quantitative ease abound right next door (the UK, Sweden, and Switzerland for starters).

Nevertheless, the Eurozone is decidedly on a different cycle (as Draghi again emphasized) than other countries, and any potential financial stability risk of the ECB purchasing mortgage bonds is not even close to balancing the cost of too weak or too little action to the Eurozone economy at this juncture.

As to the prospect of sovereign bond purchases (yes, they are legal and the ECB can do them), that, as we have been expecting, has been kept firmly in reserve. And perhaps most importantly, to the skeptics, it was in fact actively discussed at this meeting, and there were indeed (we suspect a small) group of Governing Council members who suggested they even roll out a QE program out at this meeting. We suspect these members didn’t think they actually could get consensus for that yet, but the point was to keep that ball in play. We were surprised at the lack of questions from reporters on the nature of that discussion – perhaps they had too much on their plates to digest already.

Further action will of course remain data and forecast dependent, and on that point we would note that while the ECB did tweak its quarterly economic projections lower, it was only a tweak from what were already extremely low levels, with a slightly bigger downward adjustment to the growth side than to the inflation forecast (see SGH 8/21/14, ‘ECB: Draghi in Jackson”).

In the meantime, we believe the current measures will be plenty enough to keep both rates and the Euro low before the ECB need even consider the more controversial sovereign QE break the glass measures perhaps later this year.

All in all, very well done…

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